At Linchpin we have been sounding the alarm bells over private credit for some 18 months now. Leverage levels have been rising, covenants have been weakening and accounting adjustments have been growing. As an example, US LBOs (Leveraged Buy-Outs) in 2019 had an average multiple of 11.5x on official EBITDA. If you remove the accounting shenanigans, it is more like 15x. And 79% of the leveraged loan market in 2019 were considered covenant-lite, compared to 19% in 2010*.
The other side which has long worried us was the lack of safe assets, traditionally US Treasuries, needed to act as collateral for repo lending, the source of a lot of short-term leverage today. We have long thought the need to increase supply of these was the real reason why the Federal Reserve changed track in January 2019 and started easing monetary policy.
Now the crisis has happened and the tide is going out. As always, the market will now find out who has been swimming commando. The consequences of being caught short depend very much on the Federal Reserve’s decisions. We know they will purchase investment grade (“IG”) debt, in the hope that lower credit spreads will come in too. How far down the credit spectrum will they be prepared to go in order to keep the financial system and the economy afloat?
The prospect of Federal Reserve support is why IG debt largely recovered its losses in March. There was a short period when market liquidity rose and bid-offer spreads widened but by the end of the month, even though spreads had widened, lower interest rates meant that returns were only about 3% down on the month. High yield spreads behaved similarly, although of course the spread widening was much greater. However, distressed spreads blew out and have failed to recover, because there is much less certainty whether or not they will eventually benefit from Fed support.
Private Equity (“PE”) firms are lobbying hard for support. CLOs (Collateralised Loan Obligations), which is the debt PE relies on for leverage, now form 72% of the total leveraged loan market. As discussed at our roundtable a few weeks ago, COVID-19 has shut off cashflow for many of the underlying assets. They won’t all go bad, of course, but there is going to be hard bargaining between the various parties who provide the new cash to keep which companies afloat and on what terms. There will be opportunities for private credit managers if they have the experience to pick the survivors and are able to negotiate effectively.
This is probably six months in the future. Right now, defaults and downgrades are just beginning, ticking up every day, and cash or near cash remains the place to be. However, no manager or investor can afford to be there forever and the time will come when investors will have to make their calls on which impaired companies will survive and which not. The former will offer good opportunities for those providing fresh cash or who have bought into existing debt at the right price and accompanied by a seat at the bargaining table. The latter, to state the obvious, will not.
It also behoves investors to be very careful with end of month NAV. When spreads widened in March it made a big difference whether funds marked at mid-price or at the bid. Even today, we suspect that the marks of many commingled funds are doubtful and would be wary of purchasing until there is more transparency of the state of the underlying assets.
We held a roundtable on this subject on 27th May, which proved full of insights from our panellists. You can find a summary of the discussion here, or please contact us for more information.
Happy hunting!
* Source: S&P/LTSA Leverage Loan Index
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